Labor Demand



Two factors: L – the number of employee-hours hired by the firm (E) and Capital (K). The marginal products of both labor and capital are assumed to positive numbers, so that hiring either more workers or more capital leads to more output.


The marginal product of labor is the slope of the total product curve, the rate of change in output as more workers are hired. Output increases at a decreasing rate – Law of diminishing returns. Marginal product of labor is defined in terms of fixed level of capital.

The average product of labor (AP) is the amount of output produced by the typical worker.


The marginal curve lies above the average curve when the average curve is rising, and the marginal curve lies below the average curve when the average curve is falling. So, the marginal curve intersects the average curve at the point where the average curve peaks.


The firm’s objective is to maximize its profits. w- the prices of labor and r-price of capital.


In the short run, the firm’s capital stock is fixed at some level Ko.   Suppose the price of the output equals $2. The eighth worker hired would then contribute $22 to the firm’s revenue. The law of diminishing returns plays



In Short run, the firm cannot increase or reduce the size of plant or purchase or sell physical equipment. – It would cost $22 to hire this worker (wage), even though her value of marginal product is only $18. From a profit-maximizing point of view, therefore, it is not worth hiring more than eight workers.

If VMP(L) kept rising, the firm would maxmize profits by expanding indefinitely. It would be then be difficult to maintain the assumption that the firm’s decisioin do not affect the price of output or the price of labor and capital. In effect, the law of diminishing returns sets limits on the size of the firm.






If the wage falls, the number of workers hired increases. When the output price increases, the value of marginal product shifts to right. A positive relationship exists between short-run employment and output price.



The short-run elasticity of labor demand is defined as the percentage change in short-run employment resulting from a 1 percent change in the wage. The elasticity is negative. For example, if the industry hires 30 workers when the wage is $20 and hires 56 workers if the wage falls to $10. The short-run elasticity is -1.733 and the labor demand is said to be elastic if the absolute value of the elasticity of labor demand curve is greater than one. If the absolute value of the elasticity is less than one, the labor demand is inelastic.




The marginal cost (MC) curve is upward sloping – as the firm expands, costs increase at an increasing rate.



The marginal cost (MC) is upward sloping- as the firm expands, costs increase at an increasing rate. the revenue from selling an additional unit of output is given by the constant output p.


In the long run, the  firm’s capital stock is not fixed. The firm can expand or shrink its plant size and equipment. Therefore, in the long run, the firm maximizing profits by choosing both how many workers to hire and how much plant and equipment to invest in.



The production function q=f(L,K).


The  firm’s costs of production.


At the cost-minimization solution P, the slope of the isocost equals the slope of the isoquant.




The scale effect (move from point P to point Q) indicates what happens to the demand for the firm’s inputs as the firm expands production. As long as capital and labor are “normal inputs,” the scale effect increases both the firm’s employment (from 25 to 40 workers) and the capital stock.

In addition to expanding its scale, the wage cut encourages the firm to adopt a different method of production, one that is more labor intensive to take advantage of the now-cheaper labor. The substitution effect must decrease the firm’s demand for capital ( moves from point Q to point R.)

If the scale effect outweighs the substitution effect, the firm hires more capital when the wage fails. The firm would use less capital if the substitution effect dominated the scale effect.


Because the long-run labor demand curve is downward sloping, the long-run elasticity of labor demand is negative. The long-run demand curve for labor is more elastic than the short-run demand curve for labor. In long-run, firms can adjust both capital and labor and can fully take advantage of changes in the price of labor. In short-run, the firm is “stuck” with a fixed capital stock and cannot adjust its size easily.


Whenever any two inputs in production can be substituted at a constant rate, the two inputs are called perfect substitutes. When two inputs are perfect complements, adding more one input has no impact on output. In this case, the isoquant between any two inputs is right-angled.


The substitution effect is very large when labor and capital are perfect substitutes. If the prices of the inputs change sufficiently, the firm will jump from one extreme to the other.

There is no substitution effect when two inputs are perfect complements.  The more curved the isoquant, the smaller the size of substitution effect. The elasticity of substitution is the measure of curvature of the isoquant.

If the isoquant is right-angles, the elasticity of substitution is zero.

If the isoquant is linear, the elasticity of substitution is infinite.



The elasticity of substitution gives the percentage change in the capital/labor ratio resulting from a  1 percent change in the relative price of labor. As the relative price of labor increases, the substitution effect tells us that the capital/labor ratio increases.




The unions often resist technological advances that increase the possibilites of subtituting between labor and capital. The specialized occupations make up a small fraction of total labor costs, the demand curve for these worker is relative inelastic.








If the cross-elasticity is positive, two inputs are said to be substitution. If the cross-elasticity is negative, the two inputs are compliments. An investment tax credit lowers the price of captial to the firm, it increases the demand for capital, reduces the demand for unskilled workes, and increases the demand for skilled workers. The technological progress can have a substantial impact on income inequality.


The unemployment rate, or the ratio of unemployed workers to labor market participants.



The elasticity of teenage employment with respect to the minimum wage is probably tween -0.1 and -0.3. In other words, a 10 percent increase in the minimum wage lowers teenage employment by between 1 and 3 percent. slide45slide46slide47slide48slide49slide50slide51slide52

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